ESMA warns fund managers to prepare for future adverse shocks

The European Securities and Markets Authority (ESMA) – the European Union’s securities markets regulator – has published a report on the preparedness of investment funds with significant exposures to corporate debt and real estate assets, warning managers to buckle up for potential future adverse liquidity and valuation shocks.

What did the report find?

The report identifies five “priority” areas for action which would enhance the preparedness of these fund categories:

  • Ongoing supervision of the alignment of the funds’ investment strategy
  • Liquidity profile and redemption policy
  • Ongoing supervision of liquidity risk assessment
  • Fund liquidity profile reporting
  • Increase of the availability and use of Liquidity Management Tools (LMTs)
  • Supervision of valuation processes in a context of valuation uncertainty

The funds exposed to corporate debt and the real estate funds under review overall managed to “adequately maintain their activities when facing redemption pressures and/or episodes of valuation uncertainty”, and only a limited number “temporarily suspended” subscriptions and redemptions.

However, the ESMA warns that these results should be “interpreted with caution as the redemption shock linked to the COVID-19 pandemic was concentrated over a short period of time”, in the midst of significant government and central bank interventions which provided support to the markets in which these funds invest. This throws some doubt on how organic the funds’ responses were, given the likelihood that they received supplemental funds.

In addition, the report found that some funds presented “potential liquidity mismatches due to their liquidity set up” that the ESMA has called to be addressed. This was especially the case for funds investing in asset classes “illiquid by nature” while offering a combination of “high redemption frequency and short notice periods”.

Concerns around the valuation of portfolio assets have emerged in the wake of the pandemic, especially for real estate funds for which the ESMA expects the crisis to have a “more significant impact over the longer term”.

Moreover, real estate funds do not frequently adopt LMTs in their standard liquidity set-up.

On the basis of these results, the ESMA has recommended that fund managers authorised under UCITS [Undertakings for Collective Investment in Transferable Securities] and AIFM [Alternative Investment Fund Managers] Directives should “enhance their preparedness to potential future adverse shocks that could lead to a deterioration in financial market liquidity and valuation uncertainty”.

Next steps for the ESMA

The ESMA said that it has “reinforced its coordination role regarding investment fund supervision” during the Covid-19 crisis, increasing its “frequent exchanges with NCAs [National Competent Authorities] on market developments and supervisory risks” – particularly on liquidity issues.

In addition, the ESMA has also organised “regular data collection” on the use of LMTs by EEA [European Economic Area] UCITS and AIFs to ensure a more thorough overview of market performance.

In response to a recommendation from the European Systemic Risk Board, the ESMA stated its intentions to “follow-up” with NCAs in relation to the “priority” areas 1, 2, and 5 in order to “foster supervisory convergence amongst NCAs in the area of liquidity risk management and valuation in stressed market conditions”.

From a financial stability perspective, the ESMA said that its aforementioned priority areas should also “reduce the risk and the impact of collective selling by funds on the financial system, by addressing the liquidity and valuation risks at the level of the investment fund”.

ESMA has confirmed it will continue to “monitor” this risk with regular assessments of the “resilience of the fund sector and participation to the development and operationalisation of the macroprudential framework for non-banks”.